Where Did All the Rogue Traders Go?

Plus: The Bank Behind the Fintechs, Metromile, Starling

Happy Thanksgiving to all American readers and welcome to another issue of Net Interest, my newsletter on financial sector themes. Each week I go deep on a topic of interest and highlight a few other trending themes underneath. If you like it, please share the joy. Thanks!

Where Did All the Rogue Traders Go?

Towards the middle of the 1990s I applied for a graduate job at Barings Bank. The bank was over two hundred years old and they wooed potential recruits with stories of grandeur. They told of how they’d financed the United States’ purchase of Louisiana, of how they had members of the Royal Family as clients. They were once even dubbed, “the sixth great European power”. Fortunately I didn’t get the job, because within a year the bank was bust.

Nick Leeson wasn’t the first rogue trader in history and, despite the controls put in place after he’d brought down Barings, he wasn’t the last. Not six months after Leeson was caught, a trader in Daiwa Bank’s New York office confessed to over ten years of unauthorised dealing activity, leading to losses of over $1 billion. The following year, a trader in London, who tried to corner the copper market, was found to have lost his firm $2.6 billion. In the years that followed there were many more: Joseph Jett, John Rusnak, Jérôme Kerviel, Kweku Adoboli, Bruno Iksil (the “London Whale”). Between 1995 and 2012, rogue traders were led away in handcuffs at a rate of one every year or two.  

These men cost their banks billions of dollars. Yet in the eyes of the public, they evoke a degree of fascination, even admiration. Their stories reveal the inner workings of finance and how it can be corrupted. Who are these men; what drove them?

The funny thing is, over the past few years no such new stories have come to light. Since around 2012, the industry has been devoid of a major rogue trading scandal. Even the market turmoil earlier this year failed to flush one out. And the opportunity to work at home – which John Rusnak used to his advantage (his home computer was found to contain a file marked ‘Fake Docs’) – has not yet prompted an incident either. 

In his short book on the matter, John Gapper asserted in 2011:

Rogue trading, it is now clear, is not an aberration but integral to the banking system. Like the cycles of financial speculation and crashes that have occurred throughout history, rogue traders are always with us.

Perhaps something’s changed?

Rogue Trader

If you’ve seen the movie Rogue Trader starring Ewan McGregor as Nick Leeson you’ll remember his explanation of a futures contract:

It's like if I agree to sell you this cup of cappuccino, which I don't yet own, at 45 cents a month from now, if I can buy the cappuccino at say, 43 cents, I make a profit. If the price goes the other way, I have to pay more and I lose. It's timing, it's buying and selling at the right moment. Sometimes espresso might be the best deal, or salt or pepper.

In the late 1980s Barings Bank didn’t trade many futures contracts. But recognising there was money to be made, they decided to branch out. In 1987 – the year the movie Wall Street was released – they opened an office in Singapore and a few years later bought a seat on the Singapore Mercantile Exchange (now part of ICE). Nick Leeson was brought in to run operations. 

In addition to overseeing operations, he was soon given a trading job. It didn’t take long before his unauthorised trading began. As a trader, his role wasn’t to make huge bets by trading outright, it was to facilitate orders on behalf of clients. In 1992, one of his colleagues made an operational error – she sold futures instead of buying them – leading to a loss of £20,000. An account numbered 88888 had been set up to harbour these kinds of operational losses and that’s where the loss was booked. But rather than let it sit, Leeson attempted to recover it by trading outright. The trouble is, he called the market wrong. Within a day the £20,000 loss turned into a £60,000 loss. 

In order to hide the loss, Leeson used his oversight of operations to move cash from accounts elsewhere in the bank. The idea was that once he’d made back the losses, those accounts could be repaid. Yet having discovered a place to bury his losses, Leeson began exploiting it. Soon he was using it to give clients unusually good prices, bolstering his status in the market. The volumes he executed for clients ballooned, and because losses were hidden, his profits went up. Peter Baring described the surge in the division’s profitability to the Bank of England as “amazing”.

It didn’t take long for Leeson to burn through all the cash he’d moved from other accounts and he had to find another way to keep going. He’d been introduced to options by some traders working for Barings in Japan, and found a way to use them to generate cash. By selling puts and calls simultaneously (known as selling straddles), he was able to lock in some cash, which was fine as long as volatility didn’t rise. At one point, a year into his endeavours, he even made back all of his losses. However, by now, he’d grown into his reputation as an ace trader and needed the loss account to sustain it. 

Unsurprisingly, the losses reappeared. In October 1993, Leeson was promoted to head of trading and settlements, all while a £32 million loss sat in account 88888. By January 1994 the losses were up to £50 million. Leeson couldn’t sell enough straddles to generate that much cash, nor could he find it in other accounts. So he pitched his bosses in London on a trading strategy that would involve buying and selling the Nikkei 225 stock index on both the Singapore Mercantile Exchange and the Osaka Exchange, where Barings also had a seat. To execute it, he needed funds wired to post as margin at the exchanges. 

As 1994 progressed, Leeson started doing less trading on behalf of clients and more outright trading for himself. Others in the market thought he had a big mystery client, and Barings themselves were none the wiser. His trading strategy was initially long the Nikkei, but soon he went short Japanese government bonds as well. The market didn’t go his way. By the end of the year, losses in account 88888 had risen to £80 million. Leeson deployed more and more risk to get out of his hole. 

By now, suspicions were being raised in London. Auditors needed to sign off on the bank’s 1994 accounts and they were looking for evidence of ¥7.78 billion in cash. Leeson booked it as a receivable to another firm and, in a foretaste of what would happen in frauds to follow, he spun up a series of forged confirmation letters. 

Meanwhile, his trading account was going from bad to worse. In mid January 1995 he was down £200 million. And then a literal earthquake shook. The Kobe earthquake (7.2 on the Richter scale) sent the Japanese market tumbling and by the close of trading he was down another £50 million. 

On 24 February 1995, Leeson was long Nikkei 225 contracts valued at £11 billion. In total, he owned 49% of the entire market in March Nikkei futures contracts and 24% of the June contracts. He was also short Japanese government bond futures contracts, equivalent to 88% of the June open interest. There was no way to unwind these positions with any kind of profit. He scribbled a note on his desk, “I’m sorry,” picked up his wife from home and fled the country.

Once the news broke, the Nikkei futures market crashed. Barings estimated its losses to be £385 million, more than they had in equity. While a bailout was being negotiated, another £200 million losses were discovered in his short options position. It was over.

Martingale Betting

Rogue trading is a peculiar type of fraud because it doesn’t offer a direct payout. Leeson took home a bonus of £150,000 in 1993 on reported trading profits of £8.8 million; in 1994 he would have taken home £450,000 if he wasn’t caught, on “profits” of £28.5 million. These are big numbers, but they are awarded at the discretion of management and it feels like there may be easier ways to cheat. 

In some cases, the incentive is to cover up losses. Leeson began with an innocent loss of just £20,000 which snowballed into a loss orders of magnitude higher. At Daiwa in New York, Toshihide Iguchi took a loss of $200,000 in 1984 and spent the next 11 years trying to work his way out of it. After executing more than 30,000 unauthorised trades he instead grew it into a loss of $1.1 billion. In each instance, the strategy was to make martingale bets

“As the spring wore on, I traded harder and harder, risking more and more,” wrote Leeson in his memoir, Rogue Trader. “I was well down, but increasingly sure that my doubling up and doubling up would pay off… This is gambling at its simplest. If you double up, you halve the amount the market needs to turn for you to make your money back, but you double the risk.”

Kahneman and Tversky showed that risk aversion reverses in the face of losses: “…a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.” This is evident in the behaviour of the rogue trader. 

Another incentive is status. Indeed, even after Leeson had recouped his initial losses, a hunger for status kept him dishonest. In 1996, Sumitomo revealed a rogue trading loss of $2.6 billion. It similarly began in an effort to close out a smaller loss, but their trader, like Leeson, grew in stature as his trading activity ballooned. He was known in the market as “Mr Copper” and “Mr 5%” because at one point he had direct control over 5% of the world’s physical copper supply. 

Jérôme Kerviel, who executed the largest rogue trading loss in history, seems to have been driven by status. 

While Leeson was fleeing from the authorities, Kerviel was still at school in Brittany, in France. He went on to university, graduating with a Master of Finance and gained a job in the middle office of the bank Société Générale. Over the next few years, he worked his way from the middle office into the front office, first becoming an assistant trader then a junior trader and finally in 2005 a full trader. From the moment he landed on the desk he was experimenting in unauthorised trades. 

In common with the traders at Barings, Kerviel’s job wasn’t to take outright risk on the direction of the market. He was reprimanded early for doing just that: taking a position in the German stock Allianz. If he could make money trading on a hedged basis, however, that was fine. The trouble is that low risk means low return and low return means low status. 

So Kerviel deployed his knowledge of middle office systems to make the bank think he was hedging his trades. He knew the time of day the system would run a check of ‘pending’ trades so he was able to book trades ahead of that time and cancel them afterwards. And he knew the system wouldn’t check if prices were out of whack with the market, so he entered offsetting trades at different prices. 

Kerviel’s career as a rogue trader began well enough with some small profits. He would place a directional trade and offset it with a fake hedge in the system. Between 2005 and 2008 he booked nearly 1,000 phantom hedges against trades in stocks like Allianz, ranging between €15 million and €135 million in size. 

Unlike Leeson, he called the direction of the market right. He went into 2007 short. By the end of March his short position amounted to €5.6 billion. Initially, the market kept going up and in the first five months of the year his losses hit €2.5 billion at their peak. By June 2007, his short book had grown to €28 billion in size. Then news hit that some Bear Stearns funds were suffering under the weight of subprime exposure and the market sold off. Kerviel’s massive short position swung into a profit, making him €500 million. He stayed short for most of the year, closing out with a €1.4 billion profit.

The problem was, he’d made too much! So Kerviel had to falsify more transactions to hide some of his profits. He massaged them down into a reported profit of €18 million. That was enough to make him one of the most profitable traders in the firm. His status was assured. 

Things had already begun to unravel, however, with people beginning to check his trades. Email had replaced fax since Leeson’s day, but the opportunity for forgery was still there. Kerviel began forging emails ostensibly from counterparties to confirm fake trades.

The reckoning came in January 2008. Kerviel had gone bullish and loaded up on DAX futures. But the market was falling and his trade turned a loss. Meanwhile, his offsetting trades were being checked and the digging led to a dead end—there was no evidence that an offsetting trade had been put on. Over the weekend of 19/20 January, investigators at Société Générale put all the pieces together. Kerviel was fired and, on Monday, Société Générale faced the task of unwinding his monster DAX position without spooking the market. It cost them €6.3 billion. 

Where Did They Go?

One of the common features shared by many rogue traders, including Leeson and Kerviel, is their familiarity with back office systems. While true that maintaining oversight of both trading functions and back office processing presents a conflict, it’s difficult to argue that simply having knowledge of systems is a bad thing. Rogue traders succeed by exploiting massive information gaps in their organisations. Senior management at Barings knew very little about the mechanics of trading derivatives and even a decade later, at Société Générale, Kerviel was installed with a boss who had limited trading experience. 

Information gaps still exist in organisations but in financial institutions they may not be widening at the rate they once were. The great rogue trading scandals occurred during a period of growing complexity in financial markets, which managers couldn’t keep up with. The pace of “innovation” in financial markets has since slowed down. More trading is going onto exchanges, more derivatives are being centrally cleared, less illiquid instruments are being traded. 

Allied to that – because with complexity comes profit – banks have become strategically less interested in the business of trading. Most rogue trading scandals occurred at banks where trading was not a core business. The economics of the business today render the business less attractive.  

Finally, there’s the impact of technology which can be deployed to flag rogue trading patterns. The problem here is that technology can itself turn rogue, as it did to bring down Knight Capital in 2012. 

Today, Nick Leeson has joined the hordes of Robinhood traders trading from home, Jérôme Kerviel continues to fight his conviction; many of their fellow rogue traders are on the compliance speaking circuit. As a group, they may be a relic. The lack of trading scandals in the past several years is a reflection that we may be past peak financialisation.

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The Bank Behind the Fintechs

Affirm and Upstart are both going through an IPO process right now. Both offer a very similar product: a high interest personal loan. Affirm offers them at rates up to 30%; Upstart offers them at rates up to 36%. 

At the front-end, things couldn’t look more different. Affirm distributes at the point of sale via merchants; Upstart relies on aggregators like Credit Karma and direct mail. The difference explains why it costs Affirm just $5 in sales and marketing to acquire one new loan, while it costs Upstart $380. (Granted, the Affirm loans are smaller-ticket; Affirm also offers 0% loans which don’t need that much selling.) 

At the back-end though, things are very similar. Both companies rent a bank charter from the same New Jersey-based bank, Cross River Bank. Affirm uses them to originate all their loans; Upstart uses them for nearly three-quarters of theirs. Both use Cross River to enable them to lend into states where usury laws forbid high interest lending. The maximum allowable interest rate in New Jersey is 30% so that’s the rate that gets exported.

The “rent-a-bank-charter” structure has come under some regulatory scrutiny over recent years, but regulators have attempted to provide some clarity and a recent settlement in Colorado lends it some credibility, as long as interest rates remain below 36%. 

Affirm buys all of its loans straight back from Cross River at a price which includes a fee. Upstart leaves some of them there in return for a fee—which makes up nearly two thirds of its overall revenue. For Cross River, this is not bad business. Its book of retained personal loans is up 40% since the beginning of the year and, in addition, it has built up a large portfolio of pandemic relief loans. The bank raised $100m of new funding in April to support its growth, ahead of a possible IPO next year. As a business that is agnostic as to whether the growth comes from Affirm or Upstart, that could be one worth waiting for. 

Metromile

Five full-stack insurtechs have emerged to lead the pack of new entrants in the US over recent years: Lemonade, Root, Metromile, Hippo and Next. Metromile is set to join the first two on the public markets following the announcement that it will merge with a SPAC.

Like Root, it operates in the auto segment, but with a ‘pay as you drive’ model rather than ‘pay how you drive’. It argues that the 65% of drivers who don’t use their cars very much subsidise the 35% who do. Clearly, with car usage down dramatically over the period of the pandemic, it has taken a hit. In its investor presentation it describes the ‘bad’ of Covid as being a 30%+ decline in premium per customer, but it offsets this with the ‘good’ that “paying per-mile saved our customers 30%+”. The synthesis is perhaps that customer loyalty will tick up. One year customer retention is 63% adjusting for company initiated cancellations, which is much higher than Root’s 33%.

Like Starling (below), Metromile has prioritised profitability over growth in the past few years. Gross written premiums have been stuck in a range between $19 million and $29 million per quarter since the beginning of 2018, peaking in 3Q 2019. Yet loss ratios have been strong, at 52% in 2Q 2020, versus Root at 70%. The reason for subdued growth may be that the company didn’t have very much capital. It hadn’t raised capital since July 2018 ($90 million) and earlier this year it laid off around 50 employees including its entire marketing team. 

Now that it’s got more capital in the bag (it’s receiving $300 million primary proceeds in the transaction), Metromile can focus on growth. Its financial projections have customer acquisition costs rocketing from $26 million per year in 2018/2019 to $128 million by 2024, with premiums growing at twice that rate. As for valuation, well, it’s a data science company not an insurer: “The only data science company in the world focused on auto insurance.”

Starling

The conventional challenger bank model is to win loads of customers and work out how to profit from them afterwards. Revolut reported 10 million customers at the end of the last financial year, during which it made a pre-tax loss of £107 million; Monzo had 3.9 million customers and a loss of £115 million.

Starling is different. It has fewer customers than the others – 1.8 million accounts – but it hit break even in October and expects to be monthly profitable from here onwards. Rather than go for numbers, it has sought out a more profitable customer. “We’ve never ‘bought’ customers with cash incentives, or promotions. We don’t have jazzy metal cards and we don’t offer ‘perks’ such as access to premium airport lounges.” Its strategy is reflected in the deposits it has gathered, which average £2,250 per account, compared with £350 at Monzo. 

The bank was one of the first fintechs to get accredited to offer government coronavirus relief loans. Over 90% of its loan book now comprises such loans. They give Starling a boost but the question remains what happens when they expire. Starling is in the process of raising a funding round. With Revolut valued at $5.5 billion, it’ll be interesting to see which the private markets value more highly: the opportunity to make existing customers profitable, or the opportunity to win profitable customers.